Recent geopolitical and economic events are a reminder that companies need to be structurally prepared to manage change and uncertainty. This is especially true for FX exposed companies, where these events often lead to currency rate volatility and increase in foreign exchange risk or FX risk.
Savvy treasury teams already know they need to manage FX risk. But the ability to achieve these results depends on having the right technology tools and processes in place as a part of an FX risk management strategy. Failure to do so can result in significant losses due to miscalculations in FX exposure, or missed strategic opportunities.
Here we discuss 3 key areas for understanding and controlling FX risk
- The types of FX exposure that lead to FX risk
- Strategies for controlling foreign exchange risk
- Using technology to implement strategies that mitigate FX risk
The Types of FX exposure that lead to FX Risk
Before discussing how to manage FX risk, it's worthwhile to recap the types of FX exposures that create FX risk.
- Transaction exposure: This risk is created when a company generates revenue or expenses in multiple currencies. For example, a Norwegian seafood company receives an order that will be paid by a UK company in 6 months in GBP. But if between the time of the order and the time of payment, Norwegian Krone (NOK) strengthens against Pound Sterling (GBP), this would mean less NOK than expected when the Norwegian seafood company converts the payment to its functional currency, and this possibility is a risk.
- Translation exposure (also accounting exposure): This risk is created when a company denominates its equities, assets, liabilities or income in a foreign currency. For example, a US company with manufacturing facilities in Holland will value those facilities in its financial statements based on an exchange rate between the US Dollar (USD) and the Euro (EUR). The risk is that, if USD strengthens against the EUR, this would mean the company reports a loss in its statements, even if there is no actual change to the facilities.
- Economic exposure (also operating exposure): This risk occurs when the nature of a company's operations mean that unexpected changes in a currency exchange rate can have a negative impact on cash flow, earnings or investments. For example, if a French company only sources the inputs for a product line from Argentina, and the Argentine peso unexpectedly increases in value, the French company may face a meaningful difference in the cost basis for its products, with no quick way to reorganise its supply chain. This could result in lower profits than planned until the company can mitigate the supply chain impact.
Depending on the type of exposure, risk mitigation can be operational or via direct FX management practices. While operational management is more unique to each company, there are general best practices for controlling FX practices to reduce FX exposure and FX risk.
Strategies for Controlling Foreign Exchange Risk
#1 Hedge Don’t Speculate
Hedging focuses on strategically reducing risk by taking a currency position that offsets a gain or loss, whereas speculation seeks to profit from changes in currency prices. There are 2 types of hedging - natural and financial.
Natural hedging means a company offsets its currency exposures by balancing them across its business operations. For example, a company might incur expenses in the same currency that it generates revenue in order to balance out the exposure to that currency.
- But a company can only effectively hedge naturally if it has accurate visibility into the currency exposures across its business and subsidiaries, and can plan operational adjustments accordingly. This is a challenge for companies, especially if they do not have easy technology services that can show them this full picture.
Financial hedging means a company uses financial instruments, such as forward contracts or swaps in order to reduce their FX risk. But there are key things a treasurer needs to have in place to use financial hedging effectively.
- Like natural hedging, financial hedging also requires that treasurers have accurate visibility into exposures across their businesses. These forecasts are key to the effective use of FX forward contracts, FX swaps and other FX instruments.
- Treasurers also need the ability to measure and control the cost of financial transactions to ensure costs are inline with the risk reduction outcome. But because the FX market operates opaquely based on transactions between key players, the true cost is often hidden from companies. Thus, treasurers require FX cost and margin checks prior to making a trade, and FX-data-driven analytics products to help them see their true costs.
#2 Monitor and Align Hedges with Forecasts
Treasurers are all too aware of the critical need to have financial forecasts that keep pace with business realities, and thus regularly revise their projections in response to day-to-day business events. Keeping accurate forecasts is challenging enough. But unless a company's financial hedges are aligned with the FX exposures in those forecasts, the company could face losses from risks that are not properly mitigated. This is why companies often have FX policies as part of their corporate governance to ensure hedges and exposures are aligned.
- As forecasts change, treasurers need an easy way to check if their financial hedges continue to cover their exposure and also to keep the company in line with its FX policy. To do this, companies need a big picture view that can map their historical trades to their adjusted future exposure, so they have insights to add more hedges where needed.
Treasurers can outperform their industry peers by using technology that constantly keeps track of hedges and exposure to support their alignment.
#3 Deal With Multiple FX Providers
This is one of the most critical strategies for companies to implement. But often companies wonder how to implement it because their primary FX provider is usually their relationship bank, which is a key for other financial needs like loans and investments. But experienced treasurers have worked out how to keep those relationships positive, while also holding their relationship bank to account by adding other providers and using data effectively for non-confrontational, yet firm cost control with their banks.
Some treasurers have found that simply exploring other options and getting a competing offer is sufficient to prompt reductions, even if they have not formally added or switched FX providers. getting a competing offer is sufficient to prompt reductions
But companies that add at least 1 new provider tend to get better rates because they can
- find out about market behaviours and how other banks would price them differently
- work with their relationship bank, but have the option and leverage to do some trades with other banks
- keep their banks responsive, as they are aware the trade flow could go to another FX provider
#4 Consolidate FX Operations
One strategy that successful treasurers employ is to allocate all their external FX trades to one entity. That one entity trades with the FX providers, and the company subsidiaries trade with that one entity instead of conducting their own trades with FX providers.
This allows for consolidated flow, which itself might prompt FX providers to offer more favourable terms. It prevents the case of different subsidiaries receiving discriminatory treatment by an FX provider. Also, the collective view provides a visibility that can improve natural hedging, thereby reducing the need and costs of financial hedges. Treasurers can also use this visibility to reduce unnecessary trade volume through more strategic trades.
Pro Tip: For example, instead of buying SEK/NOK and selling EUR/NOK, a company can instead sell EUR/SEK and reduce the number of transactions.
Using technology to implement strategies that mitigate FX risk
Many of the strategies above are dependent on having a consolidated and accurate understanding of
- FX exposure across a business and all its subsidiaries
- Financial hedges that have been executed across the entire business
- gaps between hedges and exposure, or inconsistencies with FX policy
Spreadsheets are a common way for companies to try to create this visibility and insight. But this is time consuming, error prone, and cannot leverage the market-wide data needed to unlock the insights that give companies an edge in FX risk management. But easy-to-use, software subscriptions providing FX analytics solve these issues, and often result in considerable savings and reductions in FX exposure and FX risk.